| ELECTRO SCIENTIFIC INDUSTRIES INC Item 1A Risk Factors Factors That May Affect Future Results The statements contained in this report that are not statements of historical fact, including without limitation statements containing the words “believes,” “expects” and similar words, constitute forward-looking statements that are subject to a number of risks and uncertainties |
| From time to time we may make other forward-looking statements |
| Investors are cautioned that such forward-looking statements are subject to an inherent risk that actual results may materially differ |
| The following information highlights some of the factors that could cause actual results to differ materially from the results expressed or implied by our forward-looking statements |
| Forward-looking statements should be considered in light of these factors |
| Factors that may result in such variances include, but are not limited to, the following: The industries that comprise our primary markets are volatile and unpredictable |
| Our business depends upon the capital expenditures of manufacturers of components and circuitry used in wireless communications, computers and other electronic products |
| In the past, the markets for electronic devices have experienced sharp downturns |
| During these downturns, electronics manufacturers, including our customers, have delayed or canceled capital expenditures, which has had a negative impact on our financial results |
| We cannot assure you when demand for our products will increase or that demand will not decrease |
| Even if demand for our products does increase, there may be significant fluctuations in our profitability and net sales |
| During any downturn, it will be difficult for us to maintain our sales levels |
| As a consequence, to maintain profitability we will need to reduce our operating expenses |
| For example, in December 2004 we announced an operational restructuring and reduction in force to reduce our expenses in connection with the most recent downturn |
| Our ability to quickly reduce operating expenses is dependent upon the nature of the actions we take to reduce expense and our subsequent ability to implement those actions and realize expected cost savings |
| Additionally, we may be unable to defer capital expenditures and we will need to continue to invest in certain areas such as research and development |
| An economic downturn may also cause us to incur charges related to impairment of assets and inventory write-offs and we may also experience delays in payments from our customers, which would have a negative effect on our financial results |
| Delays in manufacturing, shipment or customer acceptance of our products could substantially decrease our sales for a period |
| We depend on manufacturing flexibility to meet the changing demands of our customers |
| Any significant delay or interruption in receiving raw materials or in our manufacturing operations as a result of software deficiencies, natural disasters, or other causes could result in reduced manufacturing capabilities or delayed product deliveries, any or all of which could materially and adversely affect our results of operations |
| 9 ______________________________________________________________________ [30]Table of Contents In addition, we derive a substantial portion of our revenue from the sale of a relatively small number of products |
| Consequently, shipment and/or customer acceptance delays, including acceptance delays related to new product introductions or customizations, could significantly impact recognition of revenue and could be further magnified by announcements from us or our competitors of new products and technologies, which announcements could cause our customers to defer purchases of our systems or purchase products from our competitors |
| Any of these delays could result in a material adverse change in our results of operations for any particular period |
| Failure of critical suppliers of parts, components and manufacturing equipment to deliver sufficient quantities to us in a timely and cost-effective manner could negatively affect our business |
| We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers for those materials |
| We generally do not have guaranteed supply arrangements with our suppliers |
| We seek to reduce the risk of production and service interruptions and shortages of key parts by selecting and qualifying alternative suppliers for key parts, monitoring the financial stability of key suppliers and maintaining appropriate inventories of key parts |
| Although we make reasonable efforts to ensure that parts are available from multiple suppliers, some key parts are available only from a single supplier or a limited group of suppliers in the short term |
| Operations at our suppliers’ facilities are subject to disruption for a variety of reasons, including changes in business relationships, competitive factors, work stoppages, and fire, earthquake, flooding or other natural disasters |
| Such disruption could interrupt our manufacturing |
| Our business may be harmed if we do not receive sufficient parts to meet our production requirements in a timely and cost-effective manner |
| We depend on a few significant customers and we do not have long-term contracts with any of our customers |
| Our top ten customers for fiscal 2006 accounted for approximately 55prca of total net sales in fiscal 2006, with three customers each accounting for more than 10prca of total net sales in fiscal 2006 |
| In addition, none of our customers has any long-term obligation to continue to buy our products or services, and any customer could delay, reduce or cease ordering our products or services at any time |
| Our markets are subject to rapid technological change, and to compete effectively we must continually introduce new products that achieve market acceptance |
| The markets for our products are characterized by rapid technological change and innovation, frequent new product introductions, changes in customer requirements and evolving industry standards |
| Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address technological changes as well as current and potential customer requirements |
| The introduction by us or by our competitors of new and enhanced products may cause our customers to defer or cancel orders for our existing products, which may harm our operating results |
| In the past we have also experienced delays in new product development |
| Similar delays may occur in the future |
| We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or, where necessary, to license these technologies from others |
| Product development delays may result from numerous factors, including: • Changing product specifications and customer requirements; • Difficulties in hiring and retaining necessary technical personnel; • Difficulties in reallocating engineering resources and overcoming resource limitations; • Difficulties with contract manufacturers; • Changing market or competitive product requirements; and • Unanticipated engineering complexities |
| 10 ______________________________________________________________________ [31]Table of Contents The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends |
| We cannot assure you that we will be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis |
| Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards |
| Any failure to respond to technological change that may render our current products or technologies obsolete could significantly harm our business |
| Our ability to reduce costs is limited by our need to invest in research and development |
| Our industry is characterized by the need for continued investment in research and development |
| Because of intense competition in the industries in which we compete, if we were to fail to invest sufficiently in research and development, our products could become less attractive to potential customers, and our business and financial condition could be materially and adversely affected |
| As a result of our need to maintain our spending levels in this area, our operating results could be materially harmed if our net sales fall below expectations |
| In addition, as a result of our emphasis on research and development and technological innovation, our operating costs may increase in the future, and research and development expenses may increase as a percentage of total operating expenses and as a percentage of net sales |
| We are exposed to the risks that others may violate our proprietary rights, and our intellectual property rights may not be well protected in foreign countries |
| Our success is dependent upon the protection of our proprietary rights |
| In the high technology industry, intellectual property is an important asset that is always at risk of infringement |
| We incur substantial costs to obtain and maintain patents and defend our intellectual property |
| For example, we have initiated litigation alleging that certain parties have violated various patents of ours, such as the action we initiated in Taiwan against All Ring Tech Co, Ltd |
| We rely upon the laws of the United States and of foreign countries in which we develop, manufacture or sell our products to protect our proprietary rights |
| However, these proprietary rights may not provide the competitive advantages that we expect or other parties may challenge, invalidate or circumvent these rights |
| Further, our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States |
| Many US companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries |
| If we fail to adequately protect our intellectual property in these countries, it could be easier for our competitors to sell competing products in foreign countries, which could result in reduced sales and gross margins |
| We may be subject to claims of intellectual property infringement |
| Several of our competitors hold patents covering a variety of technologies, applications and methods of use similar to some of those used in our products |
| From time to time, we and our customers have received correspondence from our competitors claiming that some of our products, as used by our customers, may be infringing one or more of these patents |
| Competitors or others have in the past and may in the future assert infringement claims against our customers or us with respect to current or future products or uses, and these assertions may result in costly litigation or require us to obtain a license to use intellectual property rights of others |
| If claims of infringement are asserted against our customers, those customers may seek indemnification from us for damages or expenses they incur |
| If we become subject to infringement claims, we will evaluate our position and consider the available alternatives, which may include seeking licenses to use the technology in question or defending our position |
| 11 ______________________________________________________________________ [32]Table of Contents These licenses, however, may not be available on satisfactory terms or at all |
| If we are not able to negotiate the necessary licenses on commercially reasonable terms or successfully defend our position, our financial condition and results of operations could be materially and adversely affected |
| Our business is highly competitive, and if we fail to compete effectively, our business will be harmed |
| The industries in which we operate are highly competitive |
| We face substantial competition from established competitors, some of which have greater financial, engineering, manufacturing and marketing resources than we do |
| If we are unable to compete effectively with these companies, our market share may decline and our business could be harmed |
| Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products |
| New companies may enter the markets in which we compete, or industry consolidation may occur, further increasing competition in those markets |
| Furthermore, our technological advantages may be reduced or lost as a result of technological advances by our competitors |
| Our competitors’ greater resources in the areas described above may enable them to: • Better withstand periodic downturns; • Compete more effectively on the basis of price and technology; and • More quickly develop enhancements to and new generations of products |
| We believe that our ability to compete successfully depends on a number of factors, including: • Performance of our products; • Quality of our products; • Reliability of our products; • Cost of using our products; • The ability to upgrade our products; • Consistent availability of critical components; • Our ability to ship products on the schedule required; • Quality of the technical service we provide; • Timeliness of the services we provide; • Our success in developing new products and enhancements; • Existing market and economic conditions; and • Price of our products as compared to our competitors’ products |
| We may not be able to compete successfully in the future, and increased competition may result in price reductions, reduced profit margins and loss of market share |
| The loss of key personnel or our inability to attract, retain and assimilate sufficient numbers of managerial, financial, engineering and other technical personnel could have a material effect upon our results of operations |
| Our continued success depends, in part, upon key managerial, financial, engineering and technical personnel as well as our ability to continue to attract, retain and assimilate additional personnel |
| The loss of key personnel could have a material adverse effect on our business or results of operations |
| We may not be able to retain our key managerial, financial, engineering and technical employees |
| Attracting qualified personnel may be difficult and our efforts to attract and retain these personnel may not be successful |
| In addition, we may not be able to assimilate qualified personnel, including any new members of senior management, which could disrupt our operations |
| 12 ______________________________________________________________________ [33]Table of Contents Our worldwide direct sales and service operations expose us to employer-related risks in foreign countries |
| We have established direct sales and service organizations throughout the world |
| A worldwide direct sales and service model in foreign countries involves certain risks |
| We are subject to compliance with the labor laws and other laws governing employers in the countries where our operations are located and as a result we may incur additional costs to comply with these local regulations |
| Additionally, we may encounter labor shortages or disputes that could inhibit our ability to effectively sell, market and service our products |
| If we cannot effectively manage the risks related to employing persons in foreign countries, our operating results could be adversely affected |
| We may make acquisitions in the future, and these acquisitions may subject us to risks associated with integrating these businesses into our current business |
| Although we have no commitments or agreements for any acquisitions, in the future we may make acquisitions of, or significant investments in, businesses with complementary products, services or technologies |
| Acquisitions involve numerous risks, many of which are unpredictable and beyond our control, including: • Difficulties and increased costs in connection with integration of the personnel, operations, technologies and products of acquired companies; • Diversion of management’s attention from other operational matters; • The potential loss of key employees of acquired companies; • Lack of synergy, or inability to realize expected synergies, resulting from the acquisition; • Acquired assets becoming impaired as a result of technological advancements or worse-than-expected performance by the acquired company; and • Difficulties establishing satisfactory internal controls at acquired companies |
| Our inability to effectively manage these acquisition risks could materially and adversely affect our business, financial condition and results of operations |
| In addition, if we issue equity securities to pay for an acquisition the ownership percentage of our existing shareholders would be reduced and the value of the shares held by our existing shareholders could be diluted |
| If we use cash to pay for an acquisition the payment could significantly reduce the cash that would be available to fund our operations or to use for other purposes |
| In addition, the accounting for future acquisitions could result in significant charges resulting from amortization of intangible assets related to such acquisitions |
| We may make strategic investments in development stage companies, which investments are subject to a high degree of risk, and therefore it is possible that we could lose our entire investment |
| We are exposed to the risks of operating a global business, including risks associated with exchange rate fluctuations, legal and regulatory changes and the impact of regional and global economic disruptions |
| International shipments accounted for 82prca of net sales in fiscal 2006, with 75prca of our net sales to customers in Asia |
| We expect that international shipments will continue to represent a significant percentage of net sales in the future |
| Our non-US sales, purchases and operations are subject to risks inherent in conducting business abroad, many of which are outside our control, including the following: • Periodic local or geographic economic downturns and unstable political conditions; • Price and currency exchange controls; • Fluctuation in the relative values of currencies; • Difficulties protecting intellectual property; 13 ______________________________________________________________________ [34]Table of Contents • Local labor disputes; • Shipping delays and disruptions; • Increases in shipping costs, caused by increased fuel costs or otherwise, which we may not be able to pass on to our customers; • Unexpected changes in trading policies, regulatory requirements, tariffs and other barriers; and • Difficulties in managing a global enterprise, including staffing, collecting accounts receivable, managing suppliers, distributors and representatives, and repatriation of earnings |
| Our business and operating results are subject to uncertainties arising out of the possibility of regional or global economic disruptions (including those resulting from natural disasters and outbreaks of infectious disease), the economic consequences of military action or terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce |
| In particular, due to these uncertainties we are subject to: • The risk that future tightening of immigration controls may adversely affect the residence status of non-US engineers and other key technical employees in our US facilities or our ability to hire new non-US employees in such facilities; • The risk of more frequent instances of shipping delays; and • The risk that demand for our products may not increase or may decrease |
| Failure to maintain effective internal controls could have a material adverse effect on our business, operating results and stock price |
| In connection with our fiscal 2006 audit, we documented and tested our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent registered public accounting firm addressing these assessments |
| If we fail to maintain the adequacy of our internal controls, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act |
| Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to prevent financial fraud |
| If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly |
| Our reported results of operations will be materially and adversely affected by our adoption of SFAS 123R Statement of Financial Accounting Standards Nodtta 123 (revised 2004), Share-Based Payment (SFAS 123R), which will be effective in our first quarter of fiscal 2007, will result in recognition of substantial compensation expense relating to our stock incentive plan and employee stock purchase plan |
| We currently use the intrinsic value method to measure compensation expense for stock-based awards to our employees |
| Under this standard, we generally have not recognized any compensation expense related to stock option grants or the discounts we provide under our employee stock purchase plan |
| Under the new rules, we will be required to adopt a fair value-based method for measuring the compensation expense related to employee stock awards, which will lead to substantial additional compensation expense and will have a material adverse effect on our reported results of operations |
| Note 17 to the Consolidated Financial Statements in Item 8 of this report provides our pro forma net income and earnings per share as if we had used a fair value-based method similar to the methods required under SFAS 123R to measure the compensation expense for employee stock awards during the periods presented |
| 14 ______________________________________________________________________ [35]Table of Contents Our tax rates are subject to fluctuation, which could impact our financial position, and our estimates of tax liabilities may be subject to audit, which could result in additional assessments |
| Our effective tax rates are subject to fluctuation as the income tax rates for each year are a function of: (a) the effects of a mix of profits (losses) earned by ESI and our subsidiaries in numerous tax jurisdictions with a broad range of income tax rates, (b) our ability to utilize recorded deferred tax assets, (c) taxes, interest or penalties resulting from tax audits and (d) changes in tax laws or the interpretation of such tax laws |
| Changes in the mix of these items may cause our effective tax rates to fluctuate between periods, which could have a material adverse effect on our financial position |
| We are subject to income taxes in both the United States and numerous foreign jurisdictions |
| During the ordinary course of business there are many transactions and calculations for which the ultimate tax determination is uncertain |
| Significant judgment is exercised in determining our world wide provisions for income taxes |
| Furthermore, we are regularly under audit by tax authorities |
| Although we believe our tax estimates are reasonable, the final outcome of tax audits and examinations could be materially different than what is reflected in historical income tax accruals |
| For example, in the third quarter of fiscal 2006, a significant tax benefit was recorded upon the reversal of accrued income taxes due to the statutory closure of returns for various open tax years |
| If additional taxes are assessed as a result of an examination, a material effect on our financial results, tax positions or cash flows could occur in the period or periods in which the determination is made |